New landlords often consider dipping into the pool of family and friends to fill vacancies in their rentals. After all, these people are known entities, whereas complete strangers come with unfamiliar histories.
Why, then, do some experts advise landlords to steer clear of relatives and pals? The easy answer is that doing so carries unnecessary financial risk. Specifically, landlords risk lost tax deductions and lost profits.
Here are some measures to consider if you are thinking of renting your property to some friends, or your adult children, or other relatives. If you have already leased to family or friends, see if you took the proper precautions to protect your investment.
And, if a relative or friend is living in your rental, and you’re having problems with late rent or lease violations, see our suggestions, below, for resolving problems.
Tax deductions - you risk losing yours if you rent to family
Successful landlords track income and expenses with great care. Rental income is just one number that gets recorded; equally important are a landlord’s expenses. Costs are subtracted from income (known as taking a deduction), so that the true property income is established and you know how profitable your investment property is. The government sets criteria for rental property business deductions. And if the rules aren’t followed, certain expenses cannot be deducted.
As Janet Berry-Johnson, CPA, explains in this Forbes article, “When you rent a home to a relative, such as a spouse, child, grandchild, parent, grandparent, or sibling, any day rented at less than the fair rental price is considered a personal use day. To avoid having the rental days considered personal days, the property must be rented at fair market rates and be the renter's principal residence.”
Otherwise, the landlord cannot claim costs as business expenses because the IRS considers the property to be the landlord’s personal residence.
Here’s a simplified view of a yearly profit/loss statement for a rental valued at the national average of $188,900 that is rented to family for $1,500 a month - $400 less than market:
- Income: $18,000
- Expenses: $0 (No costs - mortgage, taxes, insurance, repairs - can be deducted)
- Net income: $18,000
Here’s what the yearly numbers look like if the landlord is charging family members a market rent of $1,900 on the home bought for $188,900:
- Income: $22,800
- Expenses:
- Mortgage - $10,200 (assuming a 30-year mortgage, 20 percent down payment and interest rate of about 3.8 percent)
- Taxes - $2,172 (assuming the median property tax rate of 1.15 percent)
- Insurance - $986 ($822 for non-rental insurance premium)
- Repairs - $3,778 (assuming 2 percent of property value)
- Net income: $9,064
Although the above example is simplified, the math is clear: By reducing the rent for family members, in the example above, the landlord is sacrificing thousands in business deductions. For a lengthier explanation, see BiggerPockets’ helpful guide on Renting to Family Members.
Are deductions the only consideration?
Set aside the issue of whether your rental costs can be deducted. Can you expect a steady rental income from someone you know? Or, will that friend or relative balk at giving you their hard-earned money? Will they delay paying rent on time if they see you taking a vacation, or buying a new car, because they think you really don’t need the money? Are you prepared to have difficult conversations, and maybe even send eviction notices if rent goes unpaid?
Would a person close to you push the limits on rules that have been set for your rental property? For instance, would they allow friends to move in without your permission, or bring in pets in spite of rules forbidding pets? And, are you ready to issue lease violations for rule-breaking?
The important thing to remember is that your rental agreement gives tenants legal possession of your property. You can’t just tell them to move out if the relationship sours. In spite of tenants being family or friends, you can’t go into the property without proper notice. The law is on the tenants’ side with respect to possession.
So, while you and your nephew, or your sister, or coworker, or fellow club member might come to an easy understanding at the start of the term, if difficulties arise once they occupy your rental, you will be legally obligated to address them correctly.
How can problems be avoided?
If you do lease to family or friends, be upfront about your expectations. Tell them that your lease will have specific rules - and that there will be fees or other outcomes if rules aren’t followed. Of course, the landlord is responsible to fully uphold his or her legal obligations, as well. Make all of this clear before tenants take possession of (move into) the rental property.
A well-written lease is the best device for protecting both the landlord and the tenants. In fact, as Orlando property management firm Warner Quinlan, Inc., points out, “Property owners might agree verbally with their tenants that a certain amount will be paid, but there’s no documentation to prove it once those tenants stop paying. This goes wrong 99 times out of... 100. You cannot operate without a (written) lease.”
Every question that could come up through the tenants’ stay should be addressed in the lease agreement (some call this a rental agreement). This way, there is no confusion about your expectations. Here are just a few issues that a written lease should clarify:
Pets - If permitted, how many, what size, what fees?
Guests - How many allowed? How long may they stay?
Late fees - How much? What is the grace period?
Parking - Where? How many spaces?
Trash and Recycling bins - Where do they get placed? Which days?
Renewal - Does the lease automatically renew? For a year? Month to month?
Written notices are the other important tool for managing rental properties. A notice should be the landlord’s immediate response to any lease rules that are broken. Whether or not the tenant is a relative or friend, unpaid rent and other lease violations are not subjects for a verbal discussion; they are matters that must be recorded in writing and monitored until resolved. If you can’t picture yourself having a process server deliver a late rent notice to your adult children, or sister-in-law, or longtime friend, then you may need to hire a property manager who can do that for you.
No rental arrangement is guaranteed to be uncomplicated. However, honest communication at the start, a good written lease, and the ability to immediately enforce the rules you set will eliminate much of the potential for misunderstanding. They may even help preserve relationships if you decide to rent to friend or family.
The Nest summarizes it nicely in saying, “Build the proper framework from the beginning and avoid conflict.” After all, renting to friends and family isn’t the same as inviting those folks to celebrate Thanksgiving dinner at your house. It is strictly a business relationship, and must be handled like one.